The End Of Irrational Exuberance

March 15, 2001

The longest economic expansion in American history turns 10 years old this month. Some birthday.

Strike that. The longest expansion will turn 10 if the economy is still eking out some small sliver of growth. Nobody knows for sure yet if that's the case, or if the economy has slipped into recession.

Wall Street's all but screaming that it has. The stock market, though, has been notorious for predicting economic doom that never materialized.

Surely, the warning signs of growth screeching to a halt are everywhere. But other signs have been mixed enough to make this a moment of extraordinary uncertainty. After spending with abandon for years, American consumers and businesses alike are taking a breather. This produces its own uncertainty spiral.

Companies making cars see sales falling and decide to make fewer cars. They need fewer workers so they lay off some. The layoff news has its own ripple effect, making consumers that much more cautious about buying cars. They begin to worry about their own future economic security, even if their jobs seem to be going fine.

"Let's wait, see how things develop," is the perfectly prudent response of the typical American family. When multiplied by millions, that prudent response acts like a giant braking system for an economy that depends on consumer spending for $2 out of every $3 generated.

That brings us back to Wall Street, which is in the midst of an enormous sell-off.

People on Wall Street like to say there are only two things that drive the market: greed and fear.

When greed rules, investors reward even bad news about a company's prospects by bidding up its stock price. "Irrational exuberance," Fed Chairman Alan Greenspan famously called it in December 1996. When Greenspan uttered that line, investors barely blinked. The Dow then was around 6,400, the Nasdaq around 1,300. Check where they are today.

When fear rules, investors punish even good news about a company's prospects by pummeling its stock price. When fear rules, there is no good news. It's all bad. Fear rules today. But before you go looking for a ledge somewhere, here's some perspective.

The spectacular rise and fall of the tech-heavy Nasdaq signaled the inevitable piercing of a bubble. The Nasdaq has lost more than 60 percent of its value since a year ago when it soared above 5,000. That has hurt a lot of investors. But it is hard to argue that companies--many of which had never made a penny of profit, and dependent on extraordinary growth year after year--deserved to be valued at such high levels. They didn't.

Now we're closer to wherever the market should be. Much of a speculative bubble has been burst, and that should put stock buyers in the position where they want to be for the long haul: owning parts of companies that have real earnings and real expectations.

That doesn't mean things will now settle into a nice, comfortable lull. Compared to 1999, stocks are now on sale. Will they go lower? Who knows? The most recent sell-off in the broader market reflects the current high level of fear as much as the generally slowing economy.

An economy that has grown steadily with low inflation for 10 years and that--even after slowing sharply--still is producing enough jobs to keep unemployment near a 30-year low shouldn't be poised for catastrophe. But it could be headed for a long, painful slowdown if consumers aren't convinced future prospects are solid.